Benjamin Graham And Jeremy Siegel on IPO Investing

I do not write about IPOs often. As far as I am concerned, there is only one privately traded company in the United States that would engender “must have” status if it became traded on the stock exchange, and that would be Mars Candy (the maker of M&M’s, Snickers, Twix, 3 Musketeers, and a handful of others). Out of all the IPOs in the only past generation or so, the only worthy of truly long-term holds that could not be bought through a similar proxy would be Google, Starbucks, and Visa. It’s not something that I think about all of that often, given the strong wisdom against IPO investing given by Jeremy Siegel and Benjamin Graham on the matter.

In the case of Siegel, the admonition against investing in IPOs is based on the numbers. Siegel argued on page 14 of his book The Future for Investors, “The long-run performance of initial public offerings is dreadful, even if you are lucky enough to get the stock at the initial offering price. From 1968 through 2001, there were only 4 years when the long-term returns on a portfolio of IPOs bought at their offer price beat a comparable small stock index. Returns for investors who bought IPOs once they actually start trading do even worse.”

This is called the growth trap. Siegel writes, “The growth trap seduces investors into overpaying for the very firms and industries that drive innovation and spearhead economic expansion. This relentless pursuit of growth—through buying hot stocks, seeking exciting new technologies, or investing in the fastest-growing countries—dooms investors to poor returns. Our fixation on growth is a snare, enticing us to place our assets in what we think will be the next big thing. But the most innovative companies are rarely the best place for investors. Technological innovation, which is blindly pursued by so many seeking to ‘beat the market’ turns out to be a double-edged sword that spurs economic growth while repeatedly disappointing investors.’”

You can look at something like Microsoft. From 2000 through 2014, the business grew at 12% annually (or more precisely, earnings per share grew at a rate of 12% annually because Microsoft regularly repurchases some of its own stock). And plus, the company paid out a dividend. That sounds like a good growth stock. And yet, investors have only received 4.5% annual returns since then because Microsoft traded at 50x profits back then when its terminal P/E ratio turned out to be something in the 15-20x earnings range. To put Siegel’s “growth trap” into numerical terms, the P/E compression from when a stock goes from 50x profits or 100x profits to 15-20x profits proves to significantly reduce your total returns even when the actual growth of the business is above average.

As an aside—although Microsoft from 2000 to 2014 illustrates the general principle that explains why IPOs do not perform as well as you would expect, the Microsoft IPO in 1986 was actually the most lucrative investments you could have made over the past three decades as the shares have compounded at almost 26% annually from 1986 through 2014 to turn a $20,000 investment into $13,660,000. Here is what Siegel has to say specifically, “Investing in IPOs is much akin to playing the lottery. There will be a few huge winners, such as Microsoft and Intel, but those who regularly invest in IPOs…generally lagged the market by two to three percentage points per year.” Siegel goes on to add that four out of every five IPOs go on to underperform against a small-cap index fund from their IPO date until the time he published The Future For Investors in 2003.

I’ve examined profit-challenged tech companies on this site before, pointing that Twitter doesn’t even have a P/E ratio right now because it is losing money. The current valuation of Facebook stock at $210 billion because Chevron is also valued at $210 billion. Chevron makes $21 billion in profits per year (even in light of lower oil prices) and returns a third of that to shareholders as dividends. Facebook makes $3 billion in profits per year. Investors are currently paying 70x Facebook’s current profits. That is going to lead to underperformance at some point, when Facebook does what every other tech company (see Microsoft, Apple, Oracle, Intel for examples) does and sees its end-game P/E ratio fall into the 15-20x profit range. Put another way, if Facebook tripled its profits in the next ten years but simultaneously saw its P/E ratio come down to 20x profits, your returns with the stock from 2014 through 2024 would be 0%.

Beyond these academic considerations, Wall Street and the media’s obsession with IPO companies and the technology sector is what inspired me to regard investing as a do-it-yourself investor. When I was in college, and I saw some of my friends take internships with Goldman Sachs and JPMorgan (which heavily recruited at Washington & Lee), I would discuss what they learned from their summer work and all they talked about was the excitement over LinkedIn and Facebook IPOs (plus the speculation about when Twitter would go public) as well as guess whether Apple would beat its quarterly profit estimates. While I do not deny that good stock-market traders exist, I could not personally distinguish between someone who trades Alibaba stock on its IPO day and someone who takes $10,000 to the Casino Queen and puts it all on “red” at the Roulette Wheel.

Fortunately for me, I was able to visit a boutique investing firm that held Coca-Cola shares for decades and all sorts of trade executions that had been permanent holdings in investor’s portfolios dating back to the 1970s. This appealed to me in two days. First, it was understandable. I understand why someone thinks Nestle chocolate and ice cream and milk and cookies will be around and profitable twenty years from now, so they take a chunk of change and initiate an ownership position in the stock. This also appealed to my moral preference for making money—if you buy a stock for $10 and sell it three months later for $15, you are making a profit at the expense of someone else’s misjudgment. That’s not bad, but it’s not fulfilling either.

If, on the other hand, you own Johnson & Johnson stock for thirty years and see a $10,000 investment grow into $984,000, you can be satisfied that the wealth was made through profit growth and dividend payments that are byproducts of delivering products to people who value them (such as Tylenol and Band-Aids). There’s social value in giving people a product they want so bad they are willing to part with a very small part of their own wealth to obtain it. That style of wealth-creation appealed to me (and incidentally, it becomes easier to weather sharp declines in stock market prices because you are naturally geared towards looking at the underlying profit statements to see what the company is doing despite the price swings).

Benjamin Graham also had a nice quip on this shiny object syndrome. He said the following in the 1973 edition of The Intelligent Investor: “The speculative public is incorrigible. It will buy anything, at any price, if there seems to be some action in progress. It will fall for any company identified with “franchising”, computers, electronics, science, technology, or what have you when this particular fashion is raging. Our readers, sensible investors all, are of course above such foolishness.” In addition to this concern about the long-term durability of companies that have an initial public offering, Graham also made the practical argument that many hot IPOs drift lower in prices once the excitement wears off. Heck, even Coca-Cola stock, perhaps the most-hyped IPO in the first half of the 20th century, saw its share price fall from $40 in 1920 to under $20 in 1921 once the Atlanta soda company lost the spotlight that comes with IPO’ing.

It’s a disconnect that is important to keep in mind. You will never turn on the TV and see analysts oohing and aaahing over Hershey, General Mills, and PepsiCo. Their businesses are highly predictable, and you are almost never going to see something like 25% year-over-year growth with firms like them. The initial hurdle, though, is recognizing that the companies most frequently discussed in the financial media usually aren’t the ones that are the most suitable for long-term investment. When is the last time you ever heard a financial analyst spend a long time talking about Kraft? And yet, buying Dart & Kraft in 1980, sticking around for its renaming to Kraft in 1986, and then holding through the Philip Morris purchase all the way until the Altria spinoff would have compounded your money at 16% annually. And you would have done it by selling cheese and snacks.

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